‘Too big to fail’ a recipe for disaster, watchdog says

Big banks operate in ‘gross distortion’ of normal market: report

RonaldD. Orol

WASHINGTON (MarketWatch) — The continued existence of financial institutions that are “too big to fail” is a recipe for disaster, a key government overseer group said Tuesday in a critical report.

“These [too-big-to-fail] institutions and their leaders are incentivized to engage in precisely the sort of behavior that could trigger the next financial crisis, perpetuating a doomsday cycle of booms, busts and bailouts,” said the Office of the Special Inspector General for the Troubled Asset Relief Program, known as SIGTARP, in a quarterly report to Congress.

The report, authored by TARP’s Special Inspector General Neil Barofsky, said institutions such as Citigroup Inc.
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operate in a “gross distortion” of a normally functioning market because after the crisis that shook the economy to the brink in September 2008, they have an implicit government guarantee that they will not be allowed to fail.

Specifically, the report argues that the Treasury Department’s actions bailing out large financial firms at the height of the financial crisis — while reassuring the troubled markets at the time — also encourages future high-risk behavior by big banks.

However, Timothy Massad, the Treasury’s acting assistant secretary for financial stability, argued in a conference call with reporters that the post-crisis Dodd-Frank Act gives financial regulators a range of tools to dismantle large, systemically risky institutions in a way that would not cause collateral damage to the markets. He also insisted that TARP was critical to stave off a much wider financial crisis.

Dodd-Frank “gives us the ability address those systemic risks and to shut down or wind down those institutions,” Massad said. “This [TARP] was a very successful program that helped prevent a depression, and now will have a very low cost.”

Barofsky and Massad are scheduled to testify about the report on Wednesday before the House Committee on Oversight and Government Reform. The hearing will be the committee’s first under the oversight of Rep. Darrell Issa, R-Calif. Issa said the hearing will give the panel’s members the chance to question the Treasury Department about concerns raised “again and again” by Barofsky.

The SIGTARP report insists that a normal market is one in which an institution’s creditors, shareholders and executives bear the brunt of poor decisions, not taxpayers.

The report also says that rating agencies continue to give big banks higher credit ratings based on the existence of an implicit government backstop. It adds that creditors, in turn, give those institutions access to debt at a price that does not fully account for the risks created by their behavior.

“As long as the relevant actors (executives, ratings agencies, creditors and counterparties) believe there will be a bailout, the problems of ‘too big to fail’ will almost certainly persist,” the report states.

Mortgage-modification program FAIL

The report also argues that Treasury’s TARP-funded program to help modify mortgages for troubled homeowners on the verge of foreclosure is failing to meet its goals.

“Despite frequent retooling, [the program] continues to fall dramatically short of any meaningful standard of success,” the report said.

It found that falling estimates of the total cost of TARP — in November, the Congressional Budget Office estimated that TARP will cost $25 billion — is being driven, in part, by fewer funds being employed for mortgage modification.

The CBO estimates that the Treasury Department will only use about $12 billion of $46 billion allocated for foreclosure prevention, according to the report. The Congressional Oversight Panel, which also oversees TARP, estimates that the Treasury program will result in roughly 700,000 to 800,000 effective permanent modifications.

The Treasury reported to SIGTARP that a program launched in September called “FHA Short Refinance” that seeks to help homeowners who owe more than their home is worth only resulted in 15 refinances as of Dec. 31. The Treasury also was “unable to report any information about homeowner participation” in its Principal Reduction Alternative program, which was available to servicers in June 2010 but formally launched on Oct. 1.

Yet Treasury’s Massad defended the program, saying it has helped many homeowners. “While we haven’t achieved as many modifications as we had originally expected, the primary reason for that is that we have very strict eligibility criteria as to who we would help, and we’ve actually reached a large part of the eligible population.”

The SIGTARP report also argued that Treasury has failed to put enough pressure on big bank mortgage servicers to modify mortgages. Servicers collect a fee for administrating all aspects of a loan, including sending monthly payments to mortgage investors, maintaining records and collecting and paying taxes and insurance.

Treasury hasn’t reacted forcefully against mortgage servicers that failed to comply with its mortgage-modification programs, the report says, in part because government officials are worried that banks will be discouraged from participating at all. The Obama administration’s Home Affordable Modification Program, or HAMP, is voluntary.

“Treasury’s reaction to servicer noncompliance with the requirements of HAMP and its related programs appears to be driven largely by the fear that forcing servicers to comply with their contractual obligations will drive them away from HAMP,” the report states. “Despite nearly daily accounts of errors and more serious misconduct, Treasury reports that it has yet to impose a financial penalty on, or claw back incentives from, a single servicer for any reason other than failure to provide data.”

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